The Breakdown - What a More Aggressive Fed Means for the Housing Market

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.io, near NFTX, and produced and distributed by CoinDesk. What's going on, guys? It is Wednesday, June 15th, and today we are talking about what a more aggressive Fed means for the housing market. Before we dive in, however, a quick housekeeping note. There are two ways to listen to the breakdown. You can find the show on the Coin Desk Podcast Network feed, which features not only the breakdown, but also other great Coin desk shows, or you can listen on the breakdown-only feed,

Starting point is 00:00:47 which comes out a few hours later in the evening. Wherever you are listening, if you're enjoying the breakdown, please consider leaving a five-star rating or a review. Those things make a huge difference to the show, and I appreciate each and every one of them. Lastly, a disclosure as always, in addition to them being a sponsor of the show, I also work with FTX. So today we are going to focus on the macro side of things, but before we do, I quickly want to mention that if you've been paying any attention, you know there are big rumors swirling around Three Arrow's Capital.

Starting point is 00:01:19 Reports started early yesterday morning that a major hedge fund in the crypto space had been margin called and was potentially insolvent. Pretty soon, the community latched onto the idea that it was 3AC. Moon Overlord wrote 3A.C. in trouble. rumors swirling. Kyle and Zhu haven't tweeted or liked anything in days. Zoo took every coin and tag out of his bio, deleted his Instagram. An hour ago, they dumped 30,000 STEath and reduced all AVE positions. People think Celsius is the biggest STEth dumper, but it's 3AC and it isn't relatively close. They're dumping on every account and seed round address they have. Most looks like it's going to pay back

Starting point is 00:01:56 debts and outstanding borrowers they have. Reactions around this ranged wildly. Some were incredulous. This is one of the standout firms of this cycle, at peak thought to have more than $10 billion of assets under management. At the same time, some had wandered if and how they had weathered the implosion of Terra and Luna, where they were known to be heavily exposed. Then again, some just outright weren't going to consider it real until they had more confirmation. Well, last night we got Sue's first statement saying we were in the process of communicating with relevant parties and fully committed to working this out. A few hours after that, the block felt it had enough reputable information to publish a piece called after facing hundreds of millions of dollars in liquidations,

Starting point is 00:02:36 Three Arrows Capital's future is uncertain. The block basically says that Three AC is in the process of figuring out how to repay lenders and other counterparties after it was liquidated by top-tier lending firms in the space. Sources declined to share the names of those firms on the record for fear of reprisal, but three people said the liquidation totaled at least $400 million. So this is obviously a hugely significant event, if indeed it is the meltdown of one of this cycle's best known firms. Because of that, I didn't want to leave it untouched, but right now there is just too much unknown and unconfirmed to do a full show yet. So for now, let's move back to the macro side of things. And of course, if you've been following this story at home, we had the inflation

Starting point is 00:03:15 being transitory, which then it wasn't, and then inflation became a political problem, and then it just kept going up, and it became a real political problem, and then rates started to rise. But on top of interest rates rising, the Fed was committing to quantitative tightening as well, in the form of letting bonds expire without renewing, thus running off the balance sheets, and that was all starting this month. So now that you're up to speed, in the midst of this, of course, we have two summer FOMC meetings, one in June and one in July. As I've said in previous shows, Jerome Powell, the Fed chair, had made it abundantly clear that there were two 50-bases-point hikes all but determined for those meetings. The real question then was going to be September and what the data was suggesting the right course of action for the Fed was by then. However, last Friday inflation surprised to the upside and came in at 8.6% instead of the anticipated 8.2%.

Starting point is 00:04:05 The market freaked and the Fed seemed to start leaking that a 75 basis point hike was now on the table. Over the last couple days, that has become closer and closer to the consensus expectation. Barclays, Deutsche Bank, Goldman, J.P. Morgan, Jeffries, Nomura, T.D. and Wells all were predicting 75 basis point hikes today. We will know very shortly if that sense of increased hawkishness was in fact correct. However, that specific number isn't the only thing that Fed watchers are paying attention to at today's meeting. There is also going to be a ton of interest in changes to the terminal rate. The terminal rate is effectively the highest rate the Fed officials see the benchmark federal funds rate reaching. After every meeting, the Fed releases a thing called the dot plot, which shows the officials' expectations and predictions about future rate increases as well.

Starting point is 00:04:52 At some point in those charts, there is a peak of how high they see the overall interest rate getting. And this, of course, is a different piece of information than just how much it's going up after that meeting. Recently, the terminal rate has been between 2.5 and 3%. One of the tools the Fed has to signal to the market that they're going to stay on inflation is to raise the upper bound of expectations about where the interest rate will actually peak, where that terminal rate, in other words, will actually land. Uri and Timmer, the director of global macro at Fidelity, says in my view, whether the Fed goes 50 or 75 in June, is not as important as where the cycle ends up.

Starting point is 00:05:29 After the past few days, the terminal rate has climbed to the high threes. And what he's talking about, of course, is bond market pricing of the terminal rate, not what Fed officials think, which we'll learn later today. Jamie McGever, a markets columnist at Reuters says, extraordinary. Markets now pricing in Fed terminal rate of 3.9% in June next year, up 100 basis points in just over two weeks. Deutsche Bank is the first major house to forecast above 4%. Still, others in the market don't think the Fed is doing enough, even with this increased hawkishness. Hedge funder Bill Ackman says the Federal Reserve has allowed inflation to get out of control.

Starting point is 00:06:02 Equity and credit markets have therefore lost confidence in the Fed. Market confidence can be restored if the Fed takes aggressive action with 75 basis points tomorrow and in July, and a commitment to aggressive federal funds increases in quantitative tightening until it is clear that inflation has been tamed. Volker needed 20% federal funds for similar levels of inflation measured comparably. Assuming a 4% terminal rate gets it done is opium. Hopefully 5% to 6% gets it done if the Fed gets there quickly. Given this, you're also starting to see investors expect that there will continue to be hikes over the fall.

Starting point is 00:06:35 Goldman Sachs is now predicting 75 basis point hikes in June and July, a 50 basis point hike in September, and 25 basis point hikes in November and December. nexo lets you easily buy crypto with your bank card and earn industry leading interest rates earn up to 16% on crypto and up to 12% on stable coins nexo makes passive income easy with interest paid automatically and daily with nexo you can also borrow against your crypto at zero percent apr and exchange over 300 pairs receive a welcome bonus of up to $150 in Bitcoin until June 30th at nexo.io. That's nexo.io. This episode is brought to you by Mir, a climate neutral, high speed, and low transaction fee, layer one blockchain platform. MIR is a blockchain for a world reimagined.

Starting point is 00:07:31 Through simple, secure, and scalable technology, MIR empowers millions to invent and explore new experiences. Business, creativity, and community are being reimagined for a more sustainable and inclusive future. Reimagined your world today at neer.org. The breakdown is sponsored by FTXUS. FtXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets, with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S.

Starting point is 00:08:10 FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTCS, you pay no gas fees. Download the FTCS app today and use referral code breakdown to support the show. So that's the immediate picture. But remember, a lot of what the Fed does is try to lead the markets where they want them to go with forward guidance, even before the actions in that forward guidance are taken. So in this case, debates and interpretations are actually part of the Fed. the whole thing. You have some like Ackman above saying that the Fed has to do more, while others like

Starting point is 00:08:45 Joe Wisenthal are basically saying, how can you guys still be clamoring that the Fed isn't doing anything? He tweeted, I have to say, the more I think about it, the more mystified I am by claims that we haven't seen an aggressive tightening already. How do you crush the stock market, slam the brakes on a red hot housing market, and create a growth tech recession without it being aggressive? What I want to do now is hone in on that slam the brakes on a red hot housing market part. While the broad macro debate is inflation on the one side recession on the other and whether there's any room for a soft landing in between, some folks are looking more specifically at the real estate and housing dimensions of all of this Fed tightening. Connor Sen wrote a piece recently called Housing Market Cooldown will only lead to more dysfunction.

Starting point is 00:09:28 Here's his argument in a nutshell. Quote, the Fed's policy actions come at a hefty cost, particularly in the housing market. With mortgage rates having breached 6%, the housing market is slowing. And while this might be an acceptable short-term price to pay in the fight against inflation, it's going to create future supply chain problems once inflation is under control and we're ready for activity to pick up again. He points to layoffs in the industry for an example. Refinancings are now down 75 to 80 percent from their pandemic peak and at their lowest level in 20-plus years. Because of that, we're starting to see layoffs at companies in the mortgage sector.

Starting point is 00:10:03 What's more, companies like Compass and Redfin have both announced layoffs as well. The problem, he says, isn't the market adjusting to supply and demand, but what happens on the other side of this? Quote, the concern comes when we realize that there is a wave of tens of millions of millennials who will be looking to buy homes over the next decade. The housing market needs the construction of many more homes to meet that demand. If we're already constraining economic activity so much that it's leading to job losses, that will make it more difficult to ramp the machine back up after inflation is under control. Now, if you've listened to My Housing episode, we know that the problem with this previously red-hot market was the legacy of exactly this sort of issue, where in the wake of the global financial crisis, there was a massive reduction in home building. As construction jobs cratered,

Starting point is 00:10:52 those workers went on to other types of jobs and reskilling and opportunities and didn't come back. Housing production ran under historical norms for a decade or more, and what that meant was a a shortage of housing supply that we're still dealing with today. Sen is arguing in this piece that even if the same level of talent destruction doesn't happen exactly for the financial side of the mortgage business, restaffing in the wake of layoffs will still take time, and that means that rates will remain inflated longer than they otherwise would have needed to based on changes in Fed policy. And to be clear, it's not just the mortgage side of the housing house that seems concerning. U.S. home builder sentiment is currently at a two-year low. The National Association of

Starting point is 00:11:35 Home Builders slash Wells Fargo gauge decreased two points in June, which is its lowest level since June 2020. This marks the index's sixth straight decline. Robert Dietz, who's the chief economist at the National Association of Home Builders, points out that the problems are coming from both sides. Quote, the housing market faces both demand side and supply side challenges. Residential construction materials are up 19% year over year, with cost increases for a variety of building inputs. On the demand side of the market, the increase for mortgage rates for the first half of 2022 has priced out a significant number of prospective home buyers, end quote. Present sales were at a two-year low, and expectations for the next six months were at their

Starting point is 00:12:16 lowest since May of 2020. Following Memorial Day, demand for mortgages crashed to a 22-year low, although it rebounded somewhat this week. And right now, mortgage prices keep going up. Stephanie Link from Hightower tweets, the velocity of this move has been staggering. 30-year fixed mortgage rates at 6.28% versus 5.5% last week. Now, the question is whether this is just mortgage lenders pricing in these new bigger hikes, or if there is another dimension to this.

Starting point is 00:12:46 Remember, when the Fed does quantitative tightening, it's letting two types of assets run off its balance sheet. The first are U.S. treasuries and the second are mortgage-backed securities. One of the big questions in the market is, are there actually other buyers for these assets? For a sense of scale, in the period between April 2020 and two years later in April 2022, Fed holdings of mortgage-backed securities doubled from approximately $1.35 trillion to $2.77 trillion. In other words, it went from owning 15% of the MBS market to 32%. In advance of Fed tightening, that market has seen a ton of selling.

Starting point is 00:13:23 Mark Fontenia, who runs a mortgage analytics firm, said, The Fed has owned such a significant portion of the MBS market for so long. Now, if they want to curb that, it's a lot of paper for the market to absorb, not only from discontinued buying, but additionally from anything they would sell. What's more, when it comes to the market absorbing it, the early signs are not good. Simon Rhee, who spent 25 years at Goldman and City, wrote about the MBS market going no bid, i.e. not having any buyers, which happened on Friday. Quote, when MBS goes no bid, as they did on Friday, the price of mortgages collapses.

Starting point is 00:13:58 This means the origination pipeline becomes much more expensive. This is what helped drive the push in mortgage rates to 6 plus percent yesterday, and the Fed hasn't even started selling MBS yet. Lewis S. Barnes of Cherry Creek Mortgage wrote a great piece that ended up being picked up by tons of outlets, Zero Hedge, and others. He writes, the CPI News this morning, this was again Friday, was so awful that it changed the bond market's view of Fed trajectory. and the weakest sector broke. In bond jargon, MBS went no bid, no buyers for mortgage-backed

Starting point is 00:14:29 securities. Then a few posted prices beyond borrower demand not wanting to buy accepted penalty prices. Over night, the retail consequence has been a leap from roughly 5.5% to 6% for low-fee-30 fixed loans. The physics of collisions. The second one does the harm. When your car hits a telephone pole, no problem. Then after a slight lag, trouble comes when you hit the inside of your car. Same thing in football. Helmet on helmet is all okay, until your brain hits the inside of your skull. The same physics govern housing collisions with mortgages. At the new year, mortgages were still three-ish, in February 4. At the end of March 5, May 5 and a half. Historically, a 2 percentage point rise from cyclical trough has iced housing, the freeze underway a month ago. Now up by

Starting point is 00:15:16 three points and double January. The pause in housing between the first collision and second is elongated because of human nature. Someone desperate to buy a house is still desperate, and modestly relieved to buy even at a higher price and rate, so long as not forced into an unlimited auction. Now it's time for Wiley E. Coyote and his Acme sneakers running off into thin air and all okay until he looks down. MBS are such a weird market that other markets have not processed what is happening. Stocks are down 2% today, but would be down a hell of a lot more if considering what a full stop to housing will mean. The real concern is summed up by Adam Kaisal, who tweeted,

Starting point is 00:15:54 Something is going to break in this economy. Not something small like a hedge fund going belly up or another crypto house rolling over, but something big. You just get that sense looking at the credit market dislocations, no bids on MBS, panic Fed moves, and information leaks. Now, as I was finishing recording this and we went across the 2 p.m. Eastern Time threshold, the Fed announced that it had indeed raised rates by 75 basis. points, its biggest increase since 1994. How the market responds and what that all means will be a topic

Starting point is 00:16:26 for tomorrow. For now, I want to say thanks again to my sponsors, nexus.io, neir and FTX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.

The Breakdown - What a More Aggressive Fed Means for the Housing Market

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